PSB recapitalisation: Why Centre would do well to persuade RBI to drop some of its zeal

PSB recapitalisation: Why Centre would do well to persuade RBI to drop some of its zeal

Going by the reaction of our stock markets the day after the government announced a recapitalisation package for public sector banks (PSBs), anaemic credit growth—following from that lacklustre economic growth—will soon be a thing of the past.

Published: November 8, 2017 4:13 AM

The day after finance minister Arun Jaitley made the surprise announcement of a recapitalisation package of Rs 2.11 lakh crore over the next two years, the PSB index shot up 30%.

By-NR Bhusnurmath

Going by the reaction of our stock markets the day after the government announced a recapitalisation package for public sector banks (PSBs), anaemic credit growth—following from that lacklustre economic growth—will soon be a thing of the past. The day after finance minister Arun Jaitley made the surprise announcement of a recapitalisation package of Rs 2.11 lakh crore over the next two years, the PSB index shot up 30%. The strong vote of confidence suggests the market believes the combination of recapitalisation bonds (Rs 1.35 lakh crore), budgetary support (Rs 18,000 crore) and stake sale (Rs 58,000 crore) will provide PSBs with sufficient capital. Once they get capital, they will lend freely, credit growth will increase from the decadal low of just 7% in 2016-17, and lead to investment and economic growth. On paper, it is hard to fault markets for their optimism. But any analysis of the pros and cons of a recap package must start from first principles—the basic premise that lack of capital is the major impediment to increased bank lending. This has always been taken as the gospel truth. But is that a correct assumption? Or is it the fallout of relatively recent regulatory initiatives that could do with a re-look in the context of PSBs in a country like India where regulatory capital has a huge opportunity cost? Is recapitalising PSBs the best use of scarce taxpayer money? Or is taxpayer money better spent on building roads, bridges, irrigation canals, railway tracks, etc?

Remember, banks are not like other businesses. Modern banking is based on the fractional reserve system. What does this mean? It means that banks need to keep only a fraction of their deposits in the form of liquid cash to meet customers’ demands for withdrawal. They are free to lend the remaining deposits. And provided they choose wisely and make the right loans and investments (in terms of credit quality and appropriate maturity keeping the asset-liability mismatch in mind) so that they are able to repay depositors as and when the latter want to withdraw their deposits, they are home safe and dry.

In technical parlance, banks are highly leveraged. What does this mean? It means that, unlike other businesses where a debt-equity ratio of more than, say, 2:1 would be looked upon with askance, banks traditionally, and routinely, have much higher debt-equity ratios. In a nutshell, banks conduct their business with borrowed funds (deposits), not with capital! They do not lend their capital; they lend deposits mobilised from their customers. And provided customers have faith and continue to deposit their savings with banks, they will remain in business and continue to lend.

Walter Bagehot, noted economist, former editor of The Economist and author of Lombard Street: A Description of the Money Market (his book published in 1873), put it well. ‘A well-run bank needs no capital. No amount of capital will rescue a badly-run bank.’

That brings me to the crux of my argument. In the Indian context, the case of the Chennai-based Indian Bank is an apt example. In the late 1990s, thanks to a series of bad lending decisions (corruption?), necessitating write-offs, the bank’s net worth turned negative. Of course, the government mounted a rescue operation, appointed a new chairman (Ranjana Kumar), who did a stellar job of turning the bank around. The broader point here is that poor financial health barely dented the confidence of Indian Bank’s depositors who saw the then wholly government-owned Indian Bank as no less sound than the government of India, and continued to deposit their hard-earned savings with the bank.

This is not to say capital is not important. It is. But the requirement of capital (as distinct from the need for capital) is essentially the result of Western-led attempts, especially by the Bank of International Settlements (BIS), to provide greater comfort to depositors in the face of repeated bank failures in the West. However, as the recent experience has shown, higher capital and endless tweaks to Basel norms (from Basel 1 to the aborted Basel II and now the work-in-progress Basel III) have not been able to prevent bank failures in the West. What it has done is provide a veneer of comfort and safety when, in fact, there is none. Banks survive only as long as they enjoy the trust of the public.

In this scenario, apart from the two issues raised by doubting Thomases—one, higher capital will only ease supply-side constraints, not lack of demand for credit; two, banks are unlikely to lend unless capital infusion goes hand-in-hand with governance reforms to ensure bankers are not penalised for bona fide credit decisions that go wrong—the government will do well to ponder over a third.

Can it persuade RBI to take a slightly more nuanced (pragmatic?) view of its macro-prudential requirements, notably risk-weights and provisioning norms? RBI can take a leaf out of the books of the European Central Bank (ECB) that has decided to take a more nuanced approach to provisioning of bad loans because it realises that aggressive provisioning can hurt credit growth. Italy, in particular, has been a keen votary of this since Italian banks are not in much better shape than our own PSBs.

Surely, RBI can follow the ECB example, especially at this juncture when both the economy and banks are not exactly in the pink of health. Instead, RBI has been following an extra-conservative approach, telling banks, for instance, to assign a higher risk weight of 150% on unrated exposures of at least Rs 200 crore, including loans to quasi-sovereign public sector entities that are largely unrated.

Given that the consequences of such conservatism take a toll on the economy, the government would do well to persuade RBI to drop some of its zeal for now. It could return to it when the economy recovers. Countercyclical policies are not only for governments, but also for central banks.